08:57, July 01, 2013

When banks that are normally perceived as cash warehouses are caught in a credit crunch and there appears to be dim hope for an injection to quell the thirst for capital, it is hard for the market not to panic.

Thus, it seems natural that bank stocks fell out of favor with China's investors last Monday after the People's Bank of China (PBC), the country's central bank, published a hands-off response to the recent liquidity squeeze. Its warning letter railed against rapid credit expansion sowing trouble in the financial sector, although the PBC's urging of large banks to play their part helped interbank borrowing costs fall.

The PBC did show signs of relenting late Tuesday, issuing a statement which said it will offer liquidity assistance to cash-thirsty financial institutions that have been lending prudently in a move to belay fears of market turbulence. However, the central bank has maintained its stance to comply with Premier Li Keqiang's repeated calls for better use to be made of existing credit to support the real economy.

Rather than leading to an abrupt emergency, the situation engineered by the central bank would funnel excessive liquidity flows into runaway informal lending channels, pundits say. They further applauded this rare move made by Chinese policymakers, long used to shoveling cheap official funds into the market to feed cash-hungry banks.

Beating shadow lending

Banks that have been far too actively engaged in interbank lending as a main source of cash to keep their profits ticking over will face challenges in the wake of the incident, Jin Lin, a senior banking analyst with Orient Securities in Shanghai, told the Global Times on Wednesday. Jin pointed to the government's rising awareness of risk management in shadow finance.

The importance of deposit stability will grow in importance for banks, helping foster a sound, healthy banking system, Jin said.

For a long time, China's commercial banks have been playing a game against the central bank, especially with some getting so flexible with their money-lending that they forced the central bank to inject capital into the banking system, Guo Tianyong, director of the Research Center of China Banking at the Central University of Finance and Economics, wrote on his Weibo Wednesday.

Regarding the central bank's hands-off stance as a signal of its determination to steer credit into development of the real economy, Guo said this prudent monetary policy should continue.

The rise of trust funds and banks' wealth-management products (WMPs) beyond traditional bank loans in China is being seen as a mirror of the country's fast-growing shadow sector.

WMPs now account for 10 percent of total deposits in China's banking system, the Financial Times said in late February, pointing out that this has grown from virtually nothing in 2010.

Furthermore, according to estimates by JPMorgan Chase & Co, China's shadow lenders had almost doubled their outstanding loans between 2010 and 2012 to a total of 36 trillion yuan ($5.85 trillion), equivalent to nearly 70 percent of the nation's GDP.

In the 2013 China Financial Stability Report released on June 7, the PBC said China has no shadow banks based on international common definitions. However, some non-financial institutions engage in fundraising activities and some financial institutions carry out services characteristic of shadow banking.

But the market is divided over the severity of unintended consequences arising from the central bank's heavy-handed way of combating risks looming in the financial sector, especially regarding potential impact seeping out into the real economy.

"We expect this approach to be more effective and swift in slowing shadow activity than previous efforts," Fitch Ratings said in a statement released on June 21. It did warn that "such an approach also increases repayment risk among banks, and raises the potential for a policy mis-step and/or unintended consequences."

Over-analyzed or not?

"We think that the liquidity crisis will spill over to the broader financial sector and the real economy," Chang Jian, China economist with Barclays Capital, wrote in a research note sent to the Global Times Thursday.

"We see increased downside risks to our below-consensus economic growth forecasts for the second half," she wrote, stressing however "the probability of a meltdown of the financial system remains small."

Barclays' latest downward revision of its China growth forecast came earlier this month after the announcement of dismal export growth in May. The investment bank lowered its 2013 China growth projection to 7.4 percent from 7.9 percent.

Barclays expects financial costs to rise and for the available credit for riskier borrowers to be curtailed.

The ripple effects will be felt especially by small- and medium-sized enterprises (SMEs), which helped revitalize the economy but have long been feeling the pinch of credit shortage, Zhou Dewen, vice president of the China Association of Small and Medium Enterprises, told the Global Times Wednesday.

Lu Ting, China economist with Bank of America Merrill Lynch in Hong Kong, even expressed his harsh rhetoric in a note sent to the Global Times on Tuesday, stating "the brinkmanship displayed in dealing with these issues could be risky to China's economic stability as policymakers may not have full control of the unfolding volatilities set off by the liquidity squeeze even though the squeeze is supposed to be temporary."

But some economists believe that playing up the unintended aftermath is simply over-analyzed.

The latest wave of liquidity squeeze would have little long-term impact, Li said, downplaying fears of any catastrophe in the wake of the central bank's tough approach.

Results released Wednesday from a survey of 31 renowned experts in the financial sector that include Peng Wensheng, chief economist of China International Capital Corp, may help inject more confidence into market sentiment.

The survey conducted by Chongyang Institute for Financial Studies said that 27 of the 31 respondents saw no financial crisis in China, where it would be unlikely to see a repeat of the Lehman Brothers collapse.

Sidebar: Low prices for bankers

The interbank market is a critical component of financial capitalism, which is characterized by a predominance of the pursuit of profit from the purchase and sale of, or investment in, currencies and financial products.

Traditionally, deposit banks attract savings and lend out money to enterprises for production. With the rise of financial capitalism since the late 20th century, investment banks obtain funds on the interbank market to re-lend for investment purposes, while at the same time, investment firms act on behalf of other concerns, by selling their equities or securities to investors, for investment purposes.

This kind of casino economy has led to a preference for speculation in the financial market, which provides interest income to non-laborers, over investment for entrepreneurial growth and real production.

The interbank market is where large commercial banks buy and sell currencies among themselves on the spot, or for the short-term, for a profit, so it is also known as the spot currency market. The transactions are carried out electronically to maximize efficiency and lower the cost.

In China, such an electronic platform is based in Shanghai, namely the National Interbank Funding Center. The center is authorized to calculate and publish the prices of eight different kinds of currency trading at 11:30 am each business day.

In China, the banks have also been cooperating with trusts, another form of financial intermediary, to offer the investors wealth management products (WMPs), which are less regulated than the deposit products and carry higher risks but also higher potential profits. Because WMPs are not included in the banks' regular balance sheets, they are also known as an off-balance sheet business, or shadow banking.

When WMPs mature, the banks need to pay the investors with principals and interests, and if a bank cannot pay, then it needs to borrow. The cheapest and quickest way to source such funding is, of course, to borrow from the interbank market.

However, a interbanking crisis can happen when there is no bank willing to lend in the interbank market and the money product prices soar too high, either because, simply put, there is a run on the bank by depositors, or because an excessive amount of financial products, such as WMPs, mature at the same time.